The Federal Reserve Continues To Put Inflation First

The Federal Reserve decided earlier today to raise their benchmark Fed funds rate by 25 basis points to a range of 5.00 to 5.25%. While many believe the Fed is done with further rate hikes after this meeting, it's important to note that the Fed mentioned its desire to attain 2% inflation multiple times in today’s statement. I believe the Fed is prioritizing price stability over regional banking concerns and that further rate hikes are not off the table.

The market continues to be overly optimistic that the Fed will be easing or cutting rates in the near future. Even in the course of trading today, Fed fund futures for late 2023 through mid-2024 moved notably lower while late 2024 rate projections eased modestly. Fed fund futures for the fourth quarter of 2024 moved almost 25 basis points lower today, implying the market believes an additional cut will occur over the next 20 months, with a total of 200 basis points in rate reductions between now and the end of next year.

Fed fund futures for late 2024 are now 125 basis points lower than the projections provided by the Federal Reserve in March. The same differential exists when examining the Fed fund futures curve against its 52-week high. When examining December 2023 and December 2024 Fed fund futures history, the cause becomes abundantly clear. The failure of Silicon Valley Bank and Signature Bank created a dovish sentiment among traders that remains 100 to 125 basis points lower now than before the crisis.

The Treasury markets are in lockstep with Fed fund futures. The Treasury yield curve inversion has continued its dramatic downward steepening since March 8, with the two and three-year Treasuries falling more than 120 basis points while three-month yields have risen. The market has priced in cuts so clearly that I’m concerned we may see interest rate and stock market volatility if the Fed maintains a pause on rates over the next six months.

Since the next Fed meeting is right around the corner (June 14), I don’t see enough changing for the Fed to do anything different from what they've projected (a rate pause), but that meeting will be paramount considering new economic and rate projections will be released. Additionally, there will be a few inflation reports between now and the July meeting that will be paramount to where Fed policy will go.

Everyone agrees that inflation has moved away from its peak, but opinions are mixed regarding whether it has moderated enough. The data suggests we have a long way to go. For example, core PCE, which is the Fed’s current preferred measure of inflation, is at 4.6%. While that level is down from the peak of 5.4% in February of 2022, it is a far cry from the 3.3% projection made by the Fed for 2023 or the 2% long-term goal.

While I believe the economy is headed toward recession, the Fed cannot throw in the towel and give up on price stability before the mission is completed. Abandoning the fight against inflation now would create a set of conditions far more painful than our current situation and require even higher interest rates to alleviate.